Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Sunday, September 3, 2017

When Your Employer Bungles Your Retirement Plan Loan

I admit that
I am not a fan of borrowing from an employer retirement plan, except perhaps as
a next-to-last step before being evicted.

Things go
wrong.

Lose your
job, for example, and not only are you looking for work but you also have a tax
bill on a loan you cannot pay back.

You do not
even have to lose your job.

Ms. Frias participated
in her company’s retirement plan. She was getting ready to go on maternity
leave when she borrowed $40,000 from her 401(k). Her employer was to withhold
from her paycheck (to be paid biweekly), and there was a make-up provision
allowing her to correct any shortfall by the end of the following month.

COMMENT:
Retirement plan proceeds are normally tax-free if repaid over a period of five
years or less.

She went on
leave on or around August 1st.
She was drawing on her accumulated vacation and sick time. Sounds pretty routine.

She returned
to work October 12th.

In November,
she learned that her employer had failed to withhold any monies for her 401(k)
loan.

She
immediately wrote a $1,000 check and increased her withholding to get
caught-up.

Nonetheless,
at the end of the year the plan administrator (Mutual of America Life) sent her
a $40,000 Form 1099R on the loan.

They however
sent it to her electronically. Having no reason to expect one, she did not
realize that she had even received a 1099. Goes without saying it was not on
her tax return.

You know the
IRS matched this up and sent her a notice.

What do you
think: does she have a tax issue?

No question
her employer messed up.

And that she
tried to correct it.

However, the
law is strict:

Although a loan may satisfy the section 72(p) requirements,
“a deemed distribution occurs at the first time that the requirements … of this
section are not satisfied, in form or operation.”

Her first
payment was due in August, the month following the loan. If she had a deemed
distribution, it would have occurred then. A distribution – even a “deemed” one
– would be taxable.

There remained
hope, though:

The plan administrator may provide the
plan participant with an opportunity to cure the failure, and a deemed
distribution does not occur unless the participant fails to pay the delinquent
payment within the cure period.”

This is a
nice safety valve. If the employer gives you a “cure” period, you can still
avoid having the fail and its associated tax.

What was her
cure period?

The end of
the following month: September.

When did she
write a check?

November,
when she realized that there was a problem.

Too late.

She had one last
long shot: a “leave of absence” exception.

Which is Code
section 72(p)(2)(C), and it provides for interruption in a loan repayment
schedule if one is not drawing a paycheck or not drawing enough to meet the minimum
loan payment.

Her argument?
She was not receiving her “regular” paycheck. She instead was drawing on her vacation
and sick time bank.

Problem: she
nonetheless received a check, and the Court was unwilling to part-and-parcel
its source. She was collecting enough to make the loan payments.

She was
hosed.

She did
nothing wrong, but her employer’s negligence cost her somewhere near $15 grand
in unnecessary taxes.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.